For as much as American politicians and their constituents complain about taxes, the truth is that tax reform packages to address those complaints are rare—the last major reform of the tax code was passed in 1986 under President Ronald Reagan. But starting this week, tax talk is back in vogue in Washington D.C.
House Republicans will start to fill in the details on a tax proposal ultimately expected to reach a thousand pages. The goal is to get the bill signed into law by President Donald Trump by the end of the year. The discussions are noticeably different from the past, perhaps as expected in a time of worldwide politicization and polarization. For one thing, Republicans are the only ones doing the talking—Democrats have not yet been invited to come to the table and likely won’t if Republican leaders can muster 50 votes for passage.
Should the average American care about tax legislation beyond concern over the amount of the check we write each April 15? Yes, very much so. Our tax policies reflect the values that the country stands for. Do we cut taxes on top earners or redistribute their wealth to help the less fortunate? Should business be rewarded for helping the environment or encouraged to drill for carbon-based fuels? How do we fund government programs such as health care and entitlements? How big should government be?
"...IT WOULD BE CONSTRUCTIVE TO HAVE A DISCUSSION ABOUT WHAT WE ARE ACTUALLY TRYING TO ACHIEVE AT A BROADER LEVEL AND HOW THE TAX SYSTEM CAN HELP US GET THERE"
On a recent and unexpectedly warm day for a New England fall, Harvard Business School Working Knowledge sat down to discuss tax policy in general and reform in particular with Professor Matthew C. Weinzierl and Mihir A. Desai, the Mizuho Financial Group Professor of Finance and Professor of Law, who often testifies before congress on corporate tax issues.
A brief recap of what’s under discussion. Last month Republicans and the White House issued a nine-page framework that proposed major changes in tax rates, businesses taxes, and other items:
- Replacement of the current seven individual tax brackets with three brackets, with rates at 12 percent, 25 percent, and 35 percent.
- A 20 percent corporate tax rate, down from 39.1 percent.
- Establish a 25 percent rate for certain passthrough business income.
- For businesses doing business internationally, a territorial tax system and a one-time mandatory repatriation tax.
- Repeal of the estate tax, elimination of personal exemptions and most itemized deductions, and repeal the alternative minimum tax.
(Editor's note: The tax reform proposal has been introduced since this story was written. More details on the current plan are here.)
Transcript edited for length and clarity.
Sean Silverthorne: Why should citizens be interested in tax reform beyond what it means for their tax bill on April 15?
Matthew Weinzierl: I think of taxes as the most direct, and certainly the most important, way that we reflect some of our main values and make choices about society. Some of the biggest trade-offs we make are made when deciding tax policy.
One of the things I've been disappointed about with the talk around this particular reform is that there hasn't been much discussion of values. It's been a very mechanical discussion in a way. There isn't a lot of reference being made to principles or broader goals for the tax system, or what we're trying to do with the tax system, aside from growth. Especially in a time where you see a lot of division within the country, it would be constructive to have a discussion about what we are actually trying to achieve at a broader level and how the tax system can help us get there.
Mihir Desai: I agree completely in the sense that it's a manifestation of our values. More narrowly, it has these three really important consequences. First, we are funding the state with all it provides. Second, we redistribute to a large degree through the tax system, and that's a really important set of social decisions. Finally, we create a set of incentives for behavior and that's incredibly important.
The other way to think about why it's so important is to understand how widely and deeply the tax system impacts our lives. If you think about poverty, we now try to address it largely through the tax system via the earned income tax credit. You think about low-income housing, we do that through the tax system. If you think about health care, the ACA (Affordable Care Act) was held up because of its interpretation as a tax. If you think about the environment, you think about provisions that are associated with oil and gas, drilling, natural resource extraction. If you think about the M&A market, it's dominated by tax considerations today. The role of the tax system is very deep and wide in our society, for better or worse.
The other reason to be engaged in it is we haven't looked at it seriously for 30 years. It's something that touches every aspect of social policy. It's a much broader and deeper reflection of our values and a much broader and deeper policy instrument than we acknowledge.
Silverthorne: What are some of the fiscal realities we are ignoring in this proposal? What are the missed opportunities?
Weinzierl: On the distributional side the proposal is pretty blunt. It basically says, let's raise the standard deduction, and it's not clear exactly where the brackets will be at the low end. There is a policy, the Earned Income Tax Credit, which is bipartisan, very popular across the aisle. Thinking creatively about how to expand the reach of the EITC and using that as a lever for achieving redistribution would potentially be more powerful and popular. It's not something that's [happening], at least from what we've got so far. I find that a little frustrating.
The other thing that we're not hearing anything about a value-added tax. We're the only developed economy that doesn't do it. We have state and local sales taxes, but we don't have any broad-based value-added tax. I think most tax economists have long thought it's a strange arrow to have kept out of our quiver. There are debates about what role it would play, whether it would supplement the tax system we have now or displace part of it. Again, not to have it as part of a big tax reform is disappointing to many of us.
Desai: I think there are several big missed opportunities structurally. The first is around not thinking more seriously about a consumption tax. The destination-based cash flow tax that was proposed in the summer was effectively that in disguise. I wasn't a terrible fan of that implementation of it, but I think there's something to be said for switching to that base. The second big missed opportunity is a carbon tax.
This could be used in combination or in substitute for some kind of a consumption tax but has a variety of benefits that we should certainly explore in addition to raising revenue and has all the other benefits you'd associate with the externalities created by carbon emissions. The third missed opportunity is exploring a top bracket. A new, higher top bracket given the rise in higher incomes would be advisable. Brackets have been indexed, but high incomes have risen higher than inflation.
Significant expansion of the EITC would be the fourth big missed opportunity. Then the final one is, trying to understand better why and how so much business income has shifted to pass through entities. If anything, the framework accelerates that in really unfortunate ways. Those are really, really big missed opportunities. I appreciate the efforts, but if we wanted to really think structurally about it, I would think about all those things.
Silverthorne: This brings me to my next question, which is what are the risks involved in this framework if it's passed in the form that we know it as of now?
Desai: Well, the first is the is the fiscal consequence of the reforms. The second is, the way they think about passthroughs is really, really important. I think that could end up blowing a hole in revenues in ways we don't fully understand. The third big risk is probably that these pieces of legislation are very hard to pass. This could be a once in a 30-year opportunity. As a result, there's a real problem with making this a tax cut instead of a tax reform. That goes back to the conversation we had about revenue raisers and broader tax reforms.
Weinzierl: One of the big risks is that we actually haven't had a constructive conversation, getting back to your very first question about what we're trying to accomplish with this tax system. I mean, one way to see that concretely is the distributional implications if passed as is, with no extra top bracket and pass-through at 25 percent.
We all know inequality has been rising and it's high. There's recent research showing a substantial share of that is due to passthrough activities growing so dramatically. Now, if you cut the tax rate on passthroughs from 39.6 to 25, and you cut top rates... the vast majority of this tax cut goes to people in the top 1 percent. We can have debates about whether that's the right thing to do or not, but we aren't having that debate as part of this tax-reform process. I think that's a real missed opportunity.
Personally, I would suggest having a discussion about who's benefited from the economic system that we've been having over the last several decades and how we want that to be reflected in the tax system. Getting away a bit from the demonization of government.
Saying, "Look, government does important things. We need to pay for it. Who wants to pay for it, or who should be expected to pay for it and what would be a fair way to do that?" Those are the sorts of discussions I think we should be having. If we don't have them and instead we have a proposal that seems to lean pretty heavily in one direction distributionally, I think there is going to be a further loss of confidence or buy-in with how the system is working.
"I THINK THE DETACHMENT OF THE CURRENT DEBATE FROM FISCAL REALITIES IS REALLY DISTURBING"
Desai: I think this is a really important point that we haven't hit on. The backdrop of the income inequality debate is the shadow over the whole debate. I'm sympathetic to the concerns in the income inequality debate, but it has become such a dominant frame on the way that we think about everything that I think it's actually starting to screw things up a little bit. We understand things to be far worse than they actually are.
As a consequence, we are contemplating doing some really stupid policy things on trade and immigration, because we've convinced ourselves that we're falling apart. The reality is more nuanced. If anything, we lived through a very exceptional period where wages rose very quickly. As a consequence, we’re living through, as de Tocqueville called it, a revolution of rising expectations.
Expectations have gotten out of whack. A revolution of rising expectations is really difficult to deal with. I'm not saying that people aren't upset for good reasons. I'm just saying that we’ve lost perspective over how bad things are and therefore we are contemplating really bad ideas that will only serve to exacerbate the woes of the people who we think we’re helping.
This post was originally published on HBS Working Knowledge and the entire interview with Professor Weinzierl and Professor Desai can be viewed there.